Which of the following is correct when compensating employees with company equity?
Introduction9 minutes, 5 linksCommon questions covered here Show
What are the best equity compensation resources for startups? What is a good reference for job hunters on stock options? What should everyone know about equity compensation when joining a startup? Show 8 more Equity compensation is the practice of granting partial ownership in a company in exchange for work. In its ideal form, equity compensation aligns the interests of individual employees with the goals of the company they work for, which can yield dramatic results in team building, innovation, and longevity of employment. Each of these contributes to the creation of value—for a company, for its users and customers, and for the individuals who work to make it a success. The ways equity can be granted as compensation—including restricted stock, stock options, and restricted stock units—are notoriously complex. Equity compensation involves confounding terminology, legal obscurities, and many high-stakes decisions for those who give and receive it. If you talk to enough employees and hiring managers, you’ll hear stories of how they or their colleagues met with the painful consequences of not learning enough up front. Though many people learn the basic ideas from personal experience or from colleagues or helpful friends who have been through it before, the intricacies of equity compensation are best understood by tax attorneys, corporate lawyers, and other professionals. Understanding the technicalities of equity compensation does not guarantee that fortune will smile upon you as warmly as it did the early hires of Facebook. But a thorough overview can help you be informed when discussing with professionals for further assistance, make better decisions for your personal situation, and avoid some common and costly mistakes. Why This Guide?The first edition of this work, written by the same lead authors as the one you’re reading now, received significant feedback and discussion on Hacker News, on GitHub, and from individual experts. Now, Holloway is pleased to publish this new edition of the Guide. We’ve expanded sections, added resources and visuals, and filled in gaps. There is a lot of information about equity compensation spread across blogs and articles that focus on specific components of the topic, such as vesting, types of stock options, or equity levels. We believe there is a need for a consolidated and shared resource, written by and for people on different sides of compensation decisions, including employees, hiring managers, founders, and students. Anyone can feel overwhelmed by the complex details and high-stakes personal choices that this topic involves. This reference exists to answer the needs of beginners and the more experienced. Holloway and our contributors are motivated by a single purpose: To help readers understand important details and their contexts well enough to make better decisions themselves. The Guide aims to be practical (with concrete suggestions and pitfalls to avoid), thoughtful (with context and multiple expert perspectives, including divergent opinion on controversial topics), and concise (it is dense but contains only notable details—still, it’s at least a three-hour read, with links to three hundred sources!). The Guide does not purport to be either perfect or complete. A reference like this is always in process. That’s why we’re currently testing features to enable the Holloway community to suggest improvements, contribute new sections, and call out anything that needs revision. We welcome (and will gladly credit) your help. We especially wish to recognize the dozens of people who have helped write, review, edit, and improve it so far—and in the future—and hope you’ll check back often as it improves. ScopeCommon questions covered here What aspects of equity compensation are covered by the Holloway Guide? What aspects of equity compensation are not covered by the Holloway Guide? What is the scope of the Holloway Guide to Equity Compensation? This Guide currently covers:
Topics not yet covered:
For these situations, see other resources and get professional advice. Who May Find This UsefulCommon questions covered here Who should read the Holloway Guide to Equity Compensation? Is the Holloway Guide to Equity Compensation useful to me? Is the Holloway Guide to Equity Compensation useful to experts? Our aim is to be as helpful to the beginner as to those with more experience. Having talked with employees, CEOs, investors, and lawyers, we can assure you that no matter how much you know about equity compensation, you will likely run into confusion at some point. If you’re an employee or a candidate for a job, some of these may apply to you:
Founders or hiring managers who need to talk about equity compensation with employees or potential hires will also find this Guide useful. As many entrepreneurs and hiring managers will tell you, this topic isn’t easy on that side of the table, either! Negotiating with candidates and fielding questions from candidates and employees requires understanding the same complex technicalities of equity compensation well. That said, this topic is not simple and we ask that readers be willing to invest time to get through a lot of confusing detail. If you’re in a hurry, or you don’t care to learn the details, this Guide may not be for you. Seek advice. A Note on FairnessCommon question covered here How is the Holloway Guide to Equity Compensation useful to both hiring managers and employees? Much of what you read about equity compensation was written by a single person, from a single vantage point. The authors and editors of this Guide have navigated the territory of equity compensation from the perspective of employees, hiring managers, founders, and lawyers. We do believe that the knowledge here, combined with professional advice, can make a significant difference for both employees and hiring managers. One of the difficulties for candidates negotiating equity compensation is that they may have less information about what they are worth than the person hiring them. Companies talk to many candidates and often have access to or pay for expensive market-rate compensation data. While some data on typical equity levels have been published online, much of it fails to represent the value of a candidate with their own specific experience in a specific role. However, even without exact data, candidates and hiring managers can develop better mental frameworks to think about offers and negotiations. On the other hand, challenges are not limited to those of employees. Founders and hiring managers also often struggle with talking through the web of technicalities with potential hires, and can make equally poor decisions when making offers. Either over-compensating or under-compensating employees can have unfortunate consequences. In short, both companies and employees are routinely hurt by uninformed decisions and costly mistakes when it comes to equity compensation. A shared resource is helpful for both sides. Roadmap6 minutes, 2 linksThe Holloway ReaderCommon questions covered here What is the Holloway Reader? What are some useful features of the Holloway Reader? The Holloway Reader you’re using now is designed to help you find and navigate the material you need. Use the search box. It will reveal definitions, section-by-section results, and content contained in the hundreds of resources we’ve linked to throughout the Guide. Think of it as a mini library of the best content on equity compensation. We also provide mouseover (or short tap on mobile) for definitions of terms, related section suggestions, and external links while you read. How This Guide Is OrganizedCommon questions covered here How is the Holloway Guide to Equity Compensation organized? What are the most important topics to understanding equity compensation? This Guide contains a lot of material. And it’s dense. Some readers may wish to read front to back, but you can also search or navigate directly to parts that are of interest to you, referring back to foundational topics as needed. Equity compensation lies at the intersection of corporate law, taxation, and employee compensation, and so requires some basic understanding of all three. You might think compensation and taxation are separate topics, but they are so intertwined it would be misleading to explain one without the other. We cover material in logical order, so that if you do read the earlier sections first, later sections on the interactions of tax and compensation will be clearer. We start with Equity Compensation Basics: What compensation and equity are, and why equity is used as compensation. But before we get much further, we need to talk about what stock is, and how companies are formed. Fundamentals of Stock Corporations covers how companies organize their ownership, how stock is issued, public companies and private companies, and IPOs and liquidity (which determine when equity is worth cash). While not everyone reading this works at an early stage company, those who do can benefit from understanding the role of equity in Startups and Growth. This is good context for anyone involved in a private company that has taken on venture capital. How Equity is Granted is the core of this Guide. We describe the forms in which equity is most commonly granted, including restricted stock grants, stock options, and RSUs. Now is where it gets messier—taxes:
After these technical concerns, we move on to how you can think about all this in practice. These sections focus on scenarios common to employees and candidates, but are also of likely interest to founders and hiring managers:
Finally, we offer some additional resources:
··· When to Turn ElsewhereCEOs, CFOs, COOs, or anyone who runs a company or team of significant size should be sure to talk to an equity compensation consultant or a specialist at a law firm to learn about equity compensation plans. Founders looking for an introduction to the legalities of running a company may wish to check out Legal Concepts for Founders, from Clerky, in addition to talking to a lawyer. Founders should also lean on their investors for advice, as they may have additional experience. Executive compensation at large or public companies is an even more nuanced topic, on both sides of the table. Hire an experienced lawyer or compensation consultant. There are extensive legal resources available on executive compensation. Seeking Professional AdviceCommon questions covered here Should I seek professional advice before making decisions about equity compensation? What kind of professional should I turn to for help with equity compensation? This Guide does not replace professional advice. Please read the full disclaimer and seek professional advice from a lawyer, tax professional, or other compensation expert before making significant decisions. Does that make reading through these details a waste of time? Not at all. Important decisions rarely should or can be blindly delegated. This Guide complements but does not replace the advice you get from professionals. Working with the support of a professional can help you make better decisions when you have an understanding of the topic yourself and know what questions to ask. Equity Compensation Basics7 minutes, 25 linksCommon questions covered here How does equity compensation work? What are the fundamental concepts of equity compensation? What is the history of equity compensation? Show 10 more History and SignificanceCommon questions covered here What is the history of equity compensation? Why is equity such a significant component of executive compensation? What percentage of employees hold stock options or shares in the company they work for? Companies ranging from two-person startups to the Fortune 500 have found that granting partial ownership in a company is among the best methods to attract and retain exceptional talent. In the United States, partial ownership through stock options has been a key part of pay for executives and other employees since the 1950s.* As recently as 2014, 7.2% of all private sector employees (8.5 million people) and 13.1% of all employees of companies with stock held stock options, according to the National Center for Employee Ownership.* Many believe employee ownership has paidfostered innovations in technology, especially in Silicon Valley, from the early days of Hewlett-Packard to recent examples like Facebook. Stock options helped the first 3,000 employees of Facebook enjoy roughly $23 billion at the time the company went public.* controversy Some controversy surrounds the use of equity compensation for high-paid executives. Public companies offer executives equity compensation in no small part because of a tax loophole. In 1993, President Bill Clinton attempted to limit executive pay with a new section* of the Internal Revenue Code. Unfortunately, the legislation backfired; a loophole made performance-based pay—including stock options—fully tax deductible, thereby creating a dramatic incentive to pay executives through stock options.* From 1970–79, the average compensation for a CEO of one of the 50 largest firms in the United States was $1.2M, of which 11.2% was from stock options. By 2000–05, the same numbers had risen to $9.2M and 37%, respectively.* Growth and RiskCommon questions covered here What are the benefits of taking a pay cut to join a startup? Is it risky to accept equity as compensation? Generally, equity compensation is closely linked to the growth of a company. Cash-poor startups persuade early employees to take pay cuts and join their team by offering meaningful ownerships stakes, catering to hopes that the company will one day grow large enough to go public or be sold for an ample sum. More mature but still fast-growing companies find offering compensation linked to ownership is more attractive than high cash compensation to many candidates. With the hope for growth, however, also comes risk. Large, fast-growing companies often hit hard times. And startups routinely fail or yield no returns for investors or workers. According to a report by Cambridge Associates and Fortune Magazine, between 1990 and 2010, about 60% of venture capital-backed companies returned less than the original investment, leaving employees with the painful realization that their startup was not, in fact, the next Google. Of the remaining 40%, just a select few go on to make many of their employees wealthy, as has been the case with iconic high-growth companies, like Starbucks,* UPS,* Amazon,* Google,* or Facebook.* Compensation and EquityCommon questions covered here What is a good overview of compensation at startups? What are the basics of equity compensation at stock corporations? What does the term equity compensation mean? Definition Compensation is any remuneration to a person (including employees, contractors, advisors, founders, and board members) for services performed or rendered to a company. Compensation comes in the forms of cash pay (salary and any bonuses) and any non-cash pay, including benefits like health insurance, family-related protections, perks, and retirement plans. Company strategies for compensation are far from simple. Beth Scheer, head of talent at the venture fund Homebrew, offers a thoughtful overview of compensation in startups. Another term you may encounter is total rewards, which refers to a model of attracting and retaining employees using a combination of salary and incentive compensation (like equity), benefits, recognition for contribution or commitment (like awards and bonuses), training programs, and initiatives to improve the work environment. Definition In the context of compensation and investment, equity broadly refers to any kind of ownership in a company that can be held by individuals (like employees or board members) and by other businesses (like venture capital firms). One common kind of equity is stock, but equity can take other forms, such as stock options or warrants, that give ownership rights. Commonly, equity also comes with certain conditions, such as vesting or repurchase rights. Note the term equity also has several other technical meanings in accounting and real estate. Definition Equity compensation is the practice of granting equity in exchange for work. In this Guide we focus on equity compensation in stock corporations, the kind of company where ownership is represented by stock. (We describe stock in more detail in the next section.) Equity compensation in the form of a direct grant of stock with no strings attached is very rare. Instead, employees are given stock with additional restrictions placed on it, or are given contractual rights that later can lead to owning stock. These forms of equity compensation include restricted stock, stock options, and restricted stock units, each of which we’ll describe in detail. The Goals of Equity CompensationCommon questions covered here What are the goals of equity compensation? Why do some companies use equity as a form of compensation? What are the benefits of paying employees with equity? The purpose of equity compensation is threefold:
··· Fundamentals of Stock Corporations13 minutes, 35 linksCommon questions covered here How are stock and shares used by companies? What do I need to know about stock corporations to understand equity compensation? What is equity? Show 16 more In this section, we describe the basics of how stock and shares are used. Those familiar with stock, stock corporations, public companies, and private companies can jump ahead to how those companies grant equity. Kinds of CompaniesCommon questions covered here What kinds of companies use equity as a form of compensation? Why are most startups C corporations? What is the difference between companies and corporations? Definition A company is a legal entity formed under corporate law for the purpose of conducting trade. In the United States, specific rules and regulations govern several kinds of business entities. Federal and state law have significant implications on liability and taxation for each kind of company. Notable types of companies include sole proprietorships, partnerships, limited liability companies (LLCs), S corporations, and C corporations. Definition A corporation is a company that is legally recognized as an entity separate from its owners. The corporation itself, and not its owners, is obligated to repay debts and accountable under contracts and legal actions (that is, is a “legal person”). Most commonly, the term corporation is used to refer to a stock corporation (or joint-stock company), which is a corporation where ownership is managed using stock. Non-stock corporations that do not issue stock exist as well, the most common being nonprofit organizations. (A few less common for-profit non-stock corporations also exist.) In practice, people often use the word company to mean corporation. Definition Incorporation is the legal process of forming (or incorporating) a new corporation, such as a business or nonprofit. Corporations can be created in any country. In the United States, incorporation is handled by state law, and involves filing articles of incorporation and a variety of other required information with the Secretary of State. (Note that the formation of companies that are not corporations, such as partnerships or LLCs, is not the same as incorporation.) Definition A C corporation (or C corp) is a type of stock corporation in the United States with certain federal tax treatment. It is the most prevalent kind of corporation.* Most large, well-known American companies are C corporations. C corporations differ from S corporations and other business entities in several ways, including how income is taxed and who may own stock. C corporations have no limit on the number of shareholders allowed to own part of the company. They also allow other corporations, as well as partnerships, trusts, and other businesses, to own stock. C corps are overwhelmingly popular for early-stage private companies looking to sell part of their business in exchange for investment from individuals and organizations like venture capital firms (which are often partnerships), and for established public companies selling large numbers of stock to individuals and other companies on the public exchange. In practice, for a few reasons, these companies are usually formed in Delaware, so legalities of all this are defined in Delaware law.** You can think of Delaware law as the primary “language” of U.S. corporate law. Incorporating a company in Delaware has evolved into a national standard for high-growth companies, regardless of where they are physically located. caution This Guide focuses specifically on C corporations and does not cover how equity compensation works in LLCs, S corporations, partnerships, or sole proprietorships. Both equity and compensation are handled in significantly different ways in each of these kinds of businesses. Loosely, one way to think about companies is that they are simply a set of contracts, negotiated over time between the people who own and operate the company, and which are enforced by the government, that aligns the interests of everyone involved in creating things customers are willing to pay for. Key to these contracts is a way to precisely track ownership of the company; issuing stock is how companies often choose to do this. ··· Stock and SharesCommon questions covered here How is percentage ownership calculated? What is the difference between stock and shares? Do I need a stock certificate as proof of my ownership? Definition Stock is a legal invention that represents ownership in a company. Shares are portions of stock that allow a company to grant ownership to a variety of people or other companies in flexible ways. Each shareholder (or stockholder), as these owners are called, holds a specific number of shares. Founders, investors, employees, board members, contractors, advisors, and other companies, like law firms, can all be shareholders. Definition Stock ownership is often formalized on stock certificates, which are fancy pieces of paper that prove who owns the stock. Sometimes you have stock but don’t have the physical certificate, as it may be held for you at a law office. Some companies now manage their ownership through online services called ownership management platforms, such as Carta. If the company you work for uses an ownership management platform, you will be able to view your stock certificates and stock values online. Younger companies may also choose to keep their stock uncertificated, which means your sole evidence of ownership is your contracts with the company, and your spot on the company’s cap table, without having a separate certificate for it. Definition Outstanding shares refer to the total number of shares held by all shareholders. This number starts at an essentially arbitrary value (such as 10 million) when the company is created, and thereafter will increase as new shares are added (issued) and granted to people in exchange for money or services. Outstanding shares may increase or decrease for other reasons too, such as stock splits and share buybacks, which we won’t get into here. Later, we discuss several subtleties in how shares are counted. ··· Definition Any shareholder has a percentage ownership in the company, determined by dividing the number of shares they own by the number of outstanding shares. Although stock paperwork will always list numbers of shares, if share value is uncertain, percentage ownership is often a more meaningful number, particularly if you know or can estimate a likely valuation of the company. Even if the number of shares a person has is fixed, their percentage ownership will change over time as the outstanding shares change. Typically, this number is presented in percent or basis points (hundredths of a percent). Public and Private CompaniesCommon questions covered here What is the difference between public and private companies? What does it mean to be a public company? Are most startups private companies or public companies? Definition Public companies are corporations in which any member of the public can own stock. People can buy and sell the stock for cash on public stock exchanges. The value of a company’s shares is the value displayed in the stock market reports, so shareholders know how much their stock is worth. Definition Most smaller companies, including all startups, are private companies with owners who control how those companies operate. Unlike a public company, where anyone is able to buy and sell stock, owners of a private company control who is able to buy and sell stock. There may be few or no transactions, or they may not be publicly known. ··· GovernanceCommon questions covered here What is the purpose of a board of directors? Do all corporations have a board of directors? What is the difference between inside and outside directors on a company's board? Definition A corporation has a board of directors, a group of people whose legal obligation is to oversee the company and ensure it serves the best interests of the shareholders. Public companies are legally obligated to have a board of directors, while private companies often elect to have one. The board typically consists of inside directors, such as the CEO, one or two founders, or executives employed by the company, and outside directors, who are not involved in the day-to-day workings of the company. These board members are elected individuals who have legal, corporate governance rights and duties when it comes to voting on key company decisions. A board member is said to have a board seat at the company. Boards of directors range from 3 to 31 members, with an average size of 9; for private companies the typical board size is typically between 3 and 7 directors.* Boards are almost always an odd number in order to avoid tie votes. It’s worth noting that the state of California requires public companies to have at least one woman on their boards.* Key decisions of the board are made formally in board meetings or in writing (called written consent).* Equity grants have to be by the board of directors.* ··· IPOsCommon questions covered here What does it mean for a company to "go public"? On average, how long does it take for a private company to go from founding to IPO? Definition A private company becomes a public company in a process called an initial public offering (IPO). Historically, only private companies with a strong track record of years of growth have considered themselves ready to take this significant step. The IPO has pros and cons that include exchanging a host of high regulatory costs for the benefits of significant capital. After a company “IPOs” or “goes public,” investors and the general public can buy stock, and existing shareholders can sell their stock far more easily than when the company was private. Companies take years to IPO after being formed. The median time between a company’s founding and its IPO has been increasing. According to a Harvard report, companies that went public in 2016 took 7.7 years to do so, compared to 3.1 years for companies that went public in 1996.* ··· Sales and LiquidityCommon questions covered here What events can make a private company liquid? What is the significance of liquidity to stock corporations? danger With private companies, it can be very hard to know the value of equity. Because the value of private company stock is not determined by regular trades on public markets, shareholders can only make educated guesses about the likely future value, at a time when they will be able to sell stock. After all, private company stock is simply a legal agreement that entitles you to something of highly uncertain value, and could well be worthless in the future, or highly valuable, depending on the fate of the company. confusion We’ll discuss the notion of a company officially assigning a fair market value later, but even if a company gives you a value for your stock for tax and accounting purposes, it doesn’t mean you can expect to sell it for that value! Definition An acquisition is the purchase of more than 50% of the shares of one company (the acquired company) by another company (the purchaser). This is also called a sale of the acquired company. In an acquisition, the acquired company cedes control to the purchaser. Definition The ability to buy and sell stock is called liquidity. In startups and many private companies, it is often hard to sell stock until the company is sold or goes public, so there is little or no liquidity for shareholders until those events occur. Thus, sales and IPOs are called both exits and liquidity events. Sales, dissolutions, and bankruptcy are all called liquidations. Often people wish they could sell stock in a private company, because they would prefer having the cash. This is only possible occasionally. We get into the details later, in our section on selling private stock. Definition A dividend is a distribution of a company’s profit to shareholders, authorized by the board of directors. Established public companies and some private companies pay dividends, but this is rare among startups and companies focused on rapid growth, since they often wish to re-invest their profits into expanding the business, rather than paying that money back to shareholders. Amazon, for example, has never paid dividends. Startups and Growth16 minutes, 43 linksCommon questions covered here How do startups raise money and grow? What is the significance of rapid growth to startups? What distinguishes startups from other small businesses? Show 16 more If you’re considering working for a startup, what we cover next on how these early-stage companies raise money and grow is helpful in understanding what your equity may be worth. If you’re only concerned with large and established companies, you can skip ahead to how equity is granted. StartupsCommon questions covered here What distinguishes startups from other small businesses? What is the importance of growth in a startup? What kind of companies are startups? Definition A startup is an emerging company, typically a private company, that aspires to grow quickly in size, revenue, and influence. Once a company is established in the market and successful for a while, it usually stops being called a startup. confusion Unlike the terminology around corporations, which has legal significance, the term startup is informal, and not everyone uses it consistently. Startups are not the same as small businesses. Small businesses, like a coffee shop or plumbing business, typically intend to grow slowly and organically, while relying much less on investment capital and equity compensation. Distinguished startup investor Paul Graham has emphasized that it’s best to think of a startup as any early stage company intending to grow quickly. technical C corporations dominate the startup ecosystem. LLCs tend to be better suited for slower-growth companies that intend to distribute profits instead of re-investing them for growth. Because of this, and for complex reasons related to how their capital is raised, venture capitalists significantly prefer to invest in C corporations. ··· Fundraising, Growth, and DilutionMany large and successful companies began as startups. In general, startups rely on investors to help fund rapid growth. Definition Fundraising is the process of seeking capital to build or scale a business. Selling shares in a business to investors is one form of fundraising, as are loans and initial coin offerings. Financing refers both to fundraising from outside sources and to bringing in revenue from selling a product or service. Definition Venture capital is a form of financing for early-stage companies that individual investors or investment firms provide in exchange for partial ownership, or equity, in a company. These investors are called venture capitalists (or VCs). Venture capitalists invest in companies they perceive to be capable of growing quickly and commanding significant market share. “Venture” refers to the risky nature of investing in early-stage businesses—typically startups—with unproven business models. A startup goes through several stages of growth as it raises capital based on the hope and expectation that the company will grow and make more money in the future. Definition Companies add (or “issue”) shares during fundraising, which can be exchanged for cash from investors. As the number of outstanding shares goes up, the percentage ownership of each shareholder goes down. This is called dilution. confusion Dilution doesn’t necessarily mean that you’re losing anything as a shareholder. As a company issues stock and raises money, the smaller percentage of the company you do have could be worth more. The size of your slice gets relatively smaller, but, if the company is growing, the size of the cake gets bigger. For example, a typical startup might have three rounds of funding, with each round of funding issuing 20% more shares. At the end of the three rounds, there are more outstanding shares—roughly 73% more in this case, since 120%×120%×120% is 173%—and each shareholder owns proportionally less of the company. Definition The valuation of the company is the present value investors believe the company has. If the company is doing well, growing revenue or showing indications of future revenue (like a growing number of users or traction in a promising market), the company’s valuation will usually be on the rise. That is, the price for an investor to buy one share of the company would be increasing. danger Of course, things do not always go well, and the valuation of a company does not always go up. It can happen that a company fails entirely and all ownership stakes become worthless, or that the valuation is lower than expected and certain kinds of shares become worthless while other kinds have some value. When investors and leadership in a company expect the company to do better than it actually does, it can have a lot of disappointing consequences for shareholders. Dilution IllustrationsCommon questions covered here How is dilution best illustrated? How does dilution work for existing shareholders when the startup raises another round of funding? What happens to the value of my shares when more shares are issued? These visualizations illustrate how ownership of a venture-backed company evolves as funding is raised. One scenario imagines changes to ownership in a well-performing startup, and the other is loosely based on a careful analysis of Zipcar,* a ride-sharing company that experienced substantial dilution before eventually going public and being acquired. These diagrams simplify complexities such as the ones discussed in that analysis, but they give a sense of how ownership can be diluted. Stages of a StartupCommon questions covered here What are the typical growth stages of a startup? What is the difference between companies and corporations? What is the difference between Seed and Series A, B, and C funded startups? Understanding the value of stock and equity in a startup requires a grasp of the stages of growth a startup goes through. These stages are largely reflected in how much funding has been raised—how much ownership, in the form of shares, has been sold for capital. Very roughly, typical stages are:
Keep in mind that these numbers are more typical for startups located in California. The amount raised at various stages is typically smaller for companies located outside of Silicon Valley, where what would be called a seed round may be called a Series A in, say, Houston, Denver, or Columbus, where there are fewer companies competing for investment from fewer venture firms, and costs associated with growth (including providing livable salaries) are lower.** caution Most startups don’t get far. According to an analysis of angel investments, by Susa Ventures general partner Leo Polovets, more than half of investments fail; one in 3 are small successes (1X to 5X returns); one in 8 are big successes (5X to 30X); and one in 20 are huge successes (30X+).* ··· caution Each stage reflects the reduction of risk and increased dilution. For this reason, the amount of equity team members get is higher in the earlier stages (starting with founders) and increasingly lower as a company matures. (See the picture above.) The Option PoolCommon questions covered here What is an option pool? What percentage of stock typically makes up the option pool? How do companies decide the size of the option pool? Definition At some point early on, generally before the first employees are hired, a number of shares will be reserved for an employee option pool (or employee pool). The option pool is part of a legal structure called an equity incentive plan. A typical size for the option pool is 20% of the stock of the company, but, especially for earlier stage companies, the option pool can be 10%, 15%, or other sizes. Once the pool is established, the company’s board of directors grants stock from the pool to employees as they join the company. technical Well-advised companies will reserve in the option pool only what they expect to use over the next 12 months or so; otherwise, given how equity grants are usually promised, they may be over-granting equity. The whole pool may never be fully used, but companies should still try not to reserve more than they plan to use. The size of the pool is determined by complex factors between founders and investors. It’s worth employees (and founders) understanding that a small pool can be a good thing in that it reflects the company preserving ownership in negotiations with investors. The size of the pool may be increased later. Counting SharesCommon questions covered here How are outstanding shares counted? What is the difference between authorized but unissued, issued and outstanding, and fully diluted shares? There are some key subtleties you’re likely to come across in the way outstanding shares are counted: Definition Private companies always have what are referred to as authorized but unissued shares, referring to shares that are authorized in legal paperwork but have not actually been issued. Until they are issued, the unissued stock these shares represent doesn’t mean anything to the company or to shareholders: no one owns it. confusion For example, a corporation might have 100 million authorized shares, but will only have issued 10 million shares. In this example, the corporation would have 90 million authorized but unissued shares. When you are trying to determine what percentage a number of shares represents, you do not make reference to the authorized but unissued shares. confusion You actually want to know the total issued shares, but even this number can be confusing, as it can be computed more than one way. Typically, people count shares in two ways: issued and outstanding and fully diluted. Definition Issued and outstanding refers to the number of shares actually issued by a company to shareholders, and does not include shares that others may have an option to purchase. Definition Fully diluted refers to all of the shares that a company has issued, all of the shares that have been set aside in a stock incentive plan, and all of the shares that could be issued if all convertible securities (such as outstanding warrants) were exercised. A key difference between fully diluted shares and shares issued and outstanding is that the total of fully diluted shares will include all the shares in the employee option pool that are reserved but not yet issued to employees. important If you’re trying to figure out the likely percentage a number of shares will be worth in the future, it’s best to know the number of shares that are fully diluted. technical Even the fully diluted number may not take into account outstanding convertible securities (like convertible notes) that are waiting to be converted into stock at a future milestone. For a more complete understanding, in addition to asking about the fully-diluted capitalization you can ask about any convertible securities outstanding that are not included in that number. confusion The terminology mentioned here isn’t universally applied. It’s worth discussing these terms with your company to be sure you’re on the same page. Definition A capitalization table (cap table) is a table (often a spreadsheet or other official record) that records the ownership stakes, including number and class of shares, of all shareholders in the company. It is updated as stock is granted to new shareholders.* ··· Classes of StockCommon questions covered here What is the difference between common stock, preferred stock, and founder's stock? What factors make liquidation preference complex? What is the significance of liquidation overhang to my stock options? Definition Investors often ask for rights to be paid back first in exchange for their investment. The way these different rights are handled is by creating different classes of stock. (These are also sometimes called classes of shares, though that term has another meaning in the context of mutual funds.) Definition Two important classes of stock are common stock and preferred stock. In general, preferred stock has “rights, preferences, and privileges” that common stock does not have. Typically, investors get preferred stock, and founders and employees get common stock (or stock options). The exact number of classes of stock and the differences between them can vary company to company, and, in a startup, these can vary at each round of funding. confusion Another term you’re likely to hear is founders’ stock, which is (usually) common stock allocated at a company’s formation, but otherwise doesn’t have any different rights from other common stock.* Although preferred stock rights are too complex to cover fully, we can give a few key details: Definition Preferred stock usually has a liquidation preference (or preference), meaning the preferred stock owners will be paid before the common stock owners when a liquidity event occurs, such as if the company is sold or goes public. Definition A company is in liquidation overhang when the value of the company doesn’t reach the dollar amount investors put into it. Because of liquidation preference, those holding preferred stock (investors) will have to be paid before those holding common stock (employees). If investors have put millions of dollars into a company and it’s sold, employees’ equity won’t be worth anything if the company is in liquidation overhang and the sale doesn’t exceed that amount.* confusion The complexities of the liquidation preference are infamous. It’s worth understanding that investors and entrepreneurs negotiate a lot of the details around preferences, including:
important For the purposes of an employee who holds common stock, the most important thing to understand about preferences is that they’re not likely to matter if a company does well in the long term. In that case, every stockholder has valuable stock they can eventually sell. But if a company fails or exits for less than investors had hoped, the preferred stockholders are generally first in line to be paid back. Depending on how favorable the terms are for the investor, if the company exits at a low or modest valuation, it’s likely that common shareholders will receive little—or nothing at all. How Equity Is Granted25 minutes, 35 linksCommon questions covered here Are there different types of equity compensation? What kinds of equity do companies grant employees? What is the difference between stock options and stock grants? Show 34 more In this section we’ll lay out how equity is granted in practice, including the differences, benefits, and drawbacks of common types of equity compensation, including restricted stock awards, stock options, and restricted stock units (RSUs). We’ll go over a few less common types as well. While the intent of each kind of equity grant is similar, they differ in many ways, particularly around how they are taxed. Except in rare cases where it may be negotiable, the type of equity you get is up to the company you work for. In general, larger companies grant RSUs, and startups grant stock options, and occasionally executives and very early employees get restricted stock awards. ··· Restricted Stock AwardsCommon questions covered here What are restricted stock awards? What is restricted about restricted stock awards? Do restricted stock awards have to vest? Show 2 more At face value, the most direct approach to equity compensation would be for the company to award stock to an employee in exchange for work. In practice, it turns out a company will only want to do this with restrictions on how and when the stock is fully owned. Even so, this is actually one of the least common ways to get equity. We mention it first because it is the simplest form of equity compensation, useful for comparison as things get more complex. Definition A restricted stock award is when a company grants someone stock as a form of compensation. The stock awarded has additional conditions on it, including a vesting schedule, so is called restricted stock. Restricted stock awards may also be called simply stock awards or stock grants. technical What restricted means here is actually complex. It refers to the fact that the stock (i) has certain restrictions on it (like transfer restrictions) required for private company stock, and (ii) will be subject to repurchase at cost pursuant to a vesting schedule. The repurchase right lapses over the service-based vesting period, which is what is meant in this case by the stock “vesting.” confusion Restricted stock awards are not the same thing as restricted stock units. Typically, stock awards are limited to executives or very early hires, since once the value of the shares increases, the tax burden of receiving them (without paying the company for their value) can be too great for most people. Usually, instead of restricted stock, an employee will get stock options. Stock OptionsCommon questions covered here What is the philosophy behind granting stock options? How do stock options work? What does it mean to exercise stock options? Show 1 more Definition Stock options are contracts that allow individuals to buy a specified number of shares in the company they work for at a fixed price. Stock options are the most common way early-stage companies grant equity. Definition A person who has received a stock option grant is not a shareholder until they exercise their option, which means purchasing some or all of their shares at the strike price. Prior to exercising, an option holder does not have voting rights. Definition The strike price (or exercise price) is the fixed price per share at which stock can be purchased, as set in a stock option agreement. The strike price is generally set lower (often much lower) than what people expect will be the future value of the stock, which means selling the stock down the road could be profitable. confusion Stock options is a confusing term. In investment, an option is a right (but not an obligation) to buy something at a certain price within a certain time frame. You’ll often see stock options discussed in the context of investment. What investors in financial markets call stock options are indeed options on stock, but they are not compensatory stock options awarded for services. In this Guide, and most likely in any conversation you have with an employer, anyone who says “stock options” will be referring to compensatory stock options. confusion Stock options are not the same as stock; they are only the right to buy stock at a certain price and under a set of conditions specified in an employee’s stock option agreement. We’ll get into these conditions next. technical Although everyone typically refers to “stock options” in the plural, when you receive a stock option grant, you are receiving an option to purchase a given number of shares. So technically, it’s incorrect to say someone “has 10,000 stock options.” It’s best to understand the financial and tax implications before deciding when to exercise options. In order for the option to be tax-free to receive, the strike price must be the fair market value of the stock on the date the option is granted. technical Those familiar with stock trading (or those with economics degrees) will tell you about the Black-Scholes model, a general mathematical model for determining the value of options. While theoretically sound, this does not have as much practical application in the context of employee stock options. ··· Vesting and CliffsCommon questions covered here What is the standard vesting schedule for employee stock options at a startup? What is a cliff in a vesting schedule? How does vesting work? Show 2 more Definition Vesting is the process of gaining full legal rights to something. In the context of compensation, founders, executives, and employees typically gain rights to their grant of equity incrementally over time, subject to restrictions. People may refer to their shares or stock options vesting, or may say that a person is vesting or has fully vested. Definition In the majority of cases, vesting occurs incrementally over time, according to a vesting schedule. A person vests only while they work for the company. If the person quits or is terminated immediately, they get no equity, and if they stay for years, they’ll get most or all of it. Awards of stock, stock options, and RSUs are almost always subject to a vesting schedule. Definition Vesting schedules can have a cliff designating a length of time that a person must work before they vest at all. For example, if your equity award had a one-year cliff and you only worked for the company for 11 months, you would not get anything, since you haven’t vested in any part of your award. Similarly, if the company is sold within a year of your arrival, depending on what your paperwork says, you may receive nothing on the sale of the company. A very common vesting schedule is vesting over 4 years, with a 1 year cliff. This means you get 0% vesting for the first 12 months, 25% vesting at the 12th month, and 1/48th (2.08%) more vesting each month until the 48th month. If you leave just before a year is up, you get nothing, but if you leave after 3 years, you get 75%. Definition In some cases, vesting may be triggered by specific events outside of the vesting schedule, according to contractual terms called accelerated vesting (or acceleration). Two kinds of accelerated vesting that are commonly negotiated are if the company is sold or undergoes a merger (single trigger) or if it’s sold and the person is fired (double trigger). controversy Cliffs are an important topic. When they work well, cliffs are an effective and reasonably fair system to both employees and companies. But they can be abused and their complexity can lead to misunderstandings:
··· ··· How Options ExpireCommon questions covered here How do stock options expire? What is an exercise window? If I quit my job, how long do I have to exercise my options? Show 2 more Definition The exercise window (or exercise period) is the period during which a person can buy shares at the strike price. Options are only exercisable for a fixed period of time, until they expire, typically seven to ten years as long as the person is working for the company. But this window is not always open. danger Expiration after termination. Options can expire after you quit working for the company. Often, the expiration is 90 days after termination of service, making the options effectively worthless if you cannot exercise before that point. As we’ll get into later, you need to understand the costs, taxes, and tax liabilities of exercise and to plan ahead. In fact, you can find out when you are granted the options, or better yet, before you sign an offer letter. important Longer exercise windows. Recently (since around 2015) a few companies are finding ways to keep the exercise window open for years after leaving a company, promoting this practice as fairer to employees. Companies with extended exercise windows include Amplitude,* Clef,* Coinbase,* Pinterest,* and Quora.* However, the 90-day exercise window remains the norm. controversy The exercise window debate. Whether to have extended exercise windows has been debated at significant length. Some believe extended exercise windows are the future, arguing that a shorter window makes a company’s success a punishment to early employees. Key considerations include:
confusion Options granted to advisors typically vest over a shorter period than employee grants, often one to two years, and may have have different exercise windows. The FAST templates give some typical guidelines about this. Kinds of Stock OptionsCommon questions covered here What is the difference between statutory and non-statutory stock options? What are the pros and cons of NSOs? What are the pros and cons of ISOs? Show 1 more Definition Compensatory stock options come in two flavors, incentive stock options (ISOs) and non-qualifying stock options (NQOs, or NQSOs). Confusingly, lawyers and the IRS use several names for these two kinds of stock options, including statutory stock options and non-statutory stock options (or NSOs), respectively. In this Guide, we refer to ISOs and NSOs.
Early ExerciseCommon questions covered here What does it mean to early exercise? What happens to my unvested shares if I leave my company? What are the advantages of early exercise? Show 1 more Definition Sometimes, to help reduce the tax burden on stock options, a company will make it possible for option holders to early exercise (or forward exercise) their options, which means they can exercise even before they vest. The option holder becomes a stockholder sooner, after which the vesting applies to actual stock rather than options. This will have tax implications. caution However, the company has the right to repurchase the unvested shares, at the price paid or at the fair market value of the shares (whichever is lower), if a person quits working for the company. The company will typically repurchase the unvested shares should the person leave the company before the stock they’ve purchased vests. Restricted Stock UnitsCommon questions covered here How do RSUs work? Are restricted stock units the same as restricted stock awards? Do RSUs have to vest? Show 1 more While stock options are the most common form of equity compensation in smaller private companies, RSUs have become the most common type of equity award for public and large private companies. Facebook pioneered the use of RSUs as a private company to allow it to avoid having to register as a public company earlier. ··· Definition Restricted stock units (RSUs) refer to an agreement by a company to issue an employee shares of stock or the cash value of shares of stock on a future date. Each unit represents one share of stock or the cash value of one share of stock that the employee will receive in the future. (They’re called units since they are neither stock nor stock options, but another thing altogether that is contractually linked to the value of stock.) Definition The date on which an employee receives the shares or cash payment for RSUs is known as the settlement date.
Using Promissory Notes to Buy StockUsually you need the cash to buy shares—maybe more than you can afford to pay at exercise time. Another, less common approach to be aware of is for companies to allow the person exercising options to avoid paying the cash up front and instead accept a promise of payment in the future. Definition A company may accept a promissory note to exercise compensatory options. Essentially, a promissory note is like giving an “IOU” to the company instead of paying the company cash for shares. The note may either be a recourse promissory note or non-recourse promissory note. “Non-recourse” means the lender (the company) is prohibited from seeking a deficiency payment from the borrower (the recipient of the stock) personally if they do not pay; they only can foreclose on the property itself (in this case the stock). technical The tax consequences to the company and the optionee depend on how the note is structured. If the note is non-recourse, for state law purposes the company will consider you an owner of the shares received in exchange for the non-recourse note, but the IRS will consider the shares still an option until the promissory note is paid (which would also affect timing for long-term capital gains). technical Non-recourse promissory notes can also be used to extend option windows on stock options that are expiring (for example, after 10 years), while not requiring the holder of the options to pay until later, when the stock may be liquid or have higher value. Of course, use of promissory notes is complex and entirely at the discretion of the company. Individuals considering the idea should discuss with a lawyer as well as the company. Less Common Types of EquityCommon questions covered here What is phantom stock? What are stock appreciation rights (SARs)? Are warrants the same as stock options? While most employee equity compensation takes the form of stock, stock options, or RSUs, a complete tour of equity compensation must mention a few less common forms. Definition Phantom equity is a type of compensation award that references equity, but does not entitle the recipient to actual ownership in a company. These awards come under a variety of different monikers, but the key to understanding them is knowing that they are really just cash bonus plans, where the cash amounts are determined by reference to a company’s stock. Phantom equity can have significant value, but may be perceived as less valuable by workers because of the contractual nature of the promises. Phantom equity plans can be set up as purely discretionary bonus plans, which is less attractive than owning a piece of something. Two examples of phantom equity are phantom stock and stock appreciation rights: Definition A phantom stock award is a type of phantom equity that entitles the recipient to a payment equal to the value of a share of the company’s stock, upon the occurrence of certain events. Definition Stock appreciation rights (SARs) are a type of phantom equity that gives the recipient the right to receive a payment calculated by reference to the appreciation in the equity of the company. ··· Definition Warrants are another kind of option to purchase stock, generally used in investment transactions. For example, in a convertible note offering, investors may also get a warrant, or a law firm may ask for one in exchange for what is in essence vendor financing. They differ from stock options in that they are generally shorter, stand-alone legal documents, not granted pursuant to an equity incentive plan. In contrast, such a “plan” is intended to be used more broadly for employees, contractors, advisors, and board members. Employees and advisors may not encounter warrants, but it’s worth knowing they exist. Tax Basics11 minutes, 46 linksCommon questions covered here What are the fundamentals of income and employment tax? What are the basic tax principles I need to know to understand income tax? Can an understanding of tax basics help me navigate taxes on equity compensation? Show 11 more The awarding of equity compensation can give rise to multiple types of taxes for the recipient, including federal and state income taxes and employment taxes. Skip ahead to understand how taxes on equity work, but if you have time, this section gives a technical summary of tax fundamentals, just in case you (like most people!) never really figured out all the numbers on your pay stub. Given the complexity, most taxpayers aren’t aware of how their tax is calculated. It does take up thousands of pages* of the federal tax code and involves the intricate diversity of state tax law as well.* You don’t need to know every detail, and can rely on software and professionals to determine the tax you owe, but we do suggest understanding the different kinds of taxes, how large they can be, and how each is “triggered” by different events. confusion For those not already familiar with tax terminology, watch out: Many terms sound like regular English, but they’re not. Ordinary income, long-term and short-term, election, qualified small business, and other phrases have very specific meanings we’ll do our best to spell out. Kinds of IncomeCommon questions covered here What is the difference between ordinary income and capital gains? For tax purposes, what are the different types of income? What do I need to do to qualify for long-term capital gains? Show 1 more Definition Income is the money an individual makes. For tax purposes, there are two main types of income, which are taxed differently. Ordinary income includes wages, salary, bonuses and interest made on investments. Capital gains are the profits an individual makes from selling assets, including stock. One key difference between ordinary income and capital gains is that when capital gains taxes are calculated, consideration is given not just to the sale price of the asset but to the total gain or loss the investment incurred, each outcome having significantly different tax consequences. Definition Capital gains are classified as long-term or short-term. Long-term capital gains are the profits an individual makes from selling assets, such as stock, a business, a house, or land, that were held for more than a year. Short-term capital gains are profits from the sale of assets held for less than a year. Although this topic is not without paidcontroversy, the general idea is, if you are selling something you’ve owned for a long time, you can be taxed at a lower rate. All these rates have evolved over time based on economic and political factors,* so you can be confident they will change again in the future. new In 2017, Congress passed the Tax Cuts and Jobs Act (TCJA), which made many changes to tax rates for the 2018 tax year. Long-term capital gains taxes did not change significantly. ··· Federal TaxesCommon questions covered here What are the kinds of federal income tax I may need to pay? What is the alternative minimum tax? Under federal tax law, what is considered ordinary income? Show 2 more Definition Income tax is the money paid by individuals to federal, state, and, in some cases, local governments, and includes taxation of ordinary income and capital gains. Generally, U.S. citizens, residents, and some foreigners must file and pay federal income tax. important In general, federal tax applies to many kinds of income. If you’re an employee at a startup, you need to consider four kinds of federal tax, each of which is computed differently. confusion When it comes to equity compensation, it’s possible that you’ll have to worry about all of these, depending on your situation. That’s why we have a lot to cover here: Definition Ordinary income tax is the tax on wages or salary income, and short-term investment income. The term short-term capital gains tax may be applied to taxes on assets sold less than a year from purchase, but profits from these sales are taxed as ordinary income. For a lot of people who make most of their money by working, ordinary income tax is the biggest chunk of tax they pay. Definition Employment taxes are an additional kind of federal tax beyond ordinary income tax, and consist of Social Security and Medicare taxes that are withheld from a person’s paycheck. Employment taxes are also referred to as payroll taxes as they often show up on employee pay stubs. The Social Security wage withholding rate in 2020 is 6.2% up to the FICA wage base of $137,700. The Medicare component is 1.45%, and it does not phase out above the FICA wage base. Definition Long-term capital gains tax is a tax on the sale of assets held longer than a year. Long-term capital gains tax is often lower than ordinary income tax. Many investors hold assets for longer than a year in order to qualify for the lesser tax burden of long-term capital gains. Definition Alternative minimum tax (AMT) is a supplemental income tax that applies to certain individuals in some situations. This type of tax does not come up for many taxpayers, but higher income earners and people in special situations may have to pay large AMT bills. AMT was first enacted in 1979 in response to reports that 155 wealthy individuals had paid no income tax in 1966.* It is not the same as ordinary income tax or employment tax, and is calculated according to its own rules. ··· danger AMT is relevant to you if you’re reading this. It’s important to understand because exercising ISOs can trigger AMT. In some cases a lot of AMT, even when you haven’t sold the stock and have no money to pay. We discuss this later. Figure: Bracket Rates, Income, and TaxesSource: IRS and the Tax Foundation A bit on how all this fits together:
··· State TaxesCommon questions covered here What state has the highest long-term capital gains tax rate? What is the difference between ordinary income tax and long-term capital gains tax? Can I move to another state to avoid California's long-term capital gains tax? State tax rates and rules vary significantly. Since federal rates are much higher than state rates, you usually think of federal tax planning first. But you should also know a bit about tax rates in your state. State long-term capital gains rates range widely. California has the highest, at 13.3%; several states have none.* important For this reason, some people even consider moving to another state if they are likely to have a windfall gain, like selling a lot of stock after an IPO. ··· Taxes on Equity Compensation19 minutes, 29 linksCommon questions covered here What do I need to know about taxes and equity compensation? What are the specific tax implications of stock options and awards? What is a good overview of how equity compensation is taxed? Show 30 more Equity and taxes interact in complicated ways, and the tax consequences for an employee receiving restricted stock, stock options, or RSUs are dramatically different. This section will cover these messy details and help you make decisions that reduce the tax burden of your equity compensation. 83(b) ElectionsThis section covers one of the most important and complex decisions you may need to make regarding stock awards and stock options: paying taxes early with an 83(b) election.
Definition The Internal Revenue Code, in Section 83(b), offers taxpayers receiving equity in exchange for work the option to pay taxes on their options before they vest. If qualified, a person can tell the IRS they prefer this alternative in a process called an 83(b) election. Paying taxes early with an 83(b) election can potentially reduce taxes significantly. If the shares go up in value, the taxes owed at vesting might be far greater than the taxes owed at the time of receipt.
··· new With the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, Congress approved a new Section 83(i) that is intended to allow deferral of tax until RSU and stock option holders can sell shares to pay the tax bill. Whether companies will choose or be able to make this available to employees is not clear yet. 409A ValuationsCommon questions covered here What is a 409A valuation? What is the difference between a company's 409A valuation and its fair market value? How often is a 409A valuation needed and how long is it good for? Show 1 more When a person’s stock vests, or they exercise an option, the IRS determines the tax that person owes. But if no one is buying and selling stock, as is the case in most startups, then the value of the stock—and thus any tax owed on it—is not obvious. Definition The fair market value (FMV) of any good or property refers to a price upon which the buyer and seller have agreed, when both parties are willing, knowledgeable, and not under direct pressure to carry out the exchange. The fair market value of a company’s stock refers to the price at which a company will issue stock to its employees, and is used by the IRS to calculate how much tax an employee owes on any equity compensation they receive. The FMV of a company’s stock is determined by the company’s most recent 409A valuation. Definition A 409A valuation is an assessment private companies are required by the IRS to conduct regarding the value of any equity the company issues or offers to employees. A company wants the 409A to be low, so that employees make more off options, but not so low the IRS won’t consider it reasonable. In order to minimize the risk that a 409A valuation is manipulated to the benefit of the company, companies hire independent firms to perform 409A valuations, typically annually or after events like fundraising. The 409A valuation of employee equity is usually much less than what investors pay for preferred stock; often, it might be only a third or less of the preferred stock price. controversy Although the 409A process is required and completely standard for startups, the practice is a strange mix of formality and complete guesswork. It has been called “quite precise—remarkably inaccurate,” by venture capitalist Bill Gurley. You can read more about its nuances and controversies. ··· A 409A does have to happen every 12 months to grant the company safe harbor. A 409A also has to be done after any event that could be deemed a “material event,” which is a fancy way of saying any event that could change the price or value of the company meaningfully. Other examples could be if a CEO leaves, if the company starts making a ton of money, or if there is an acquisition.
Taxes on ISOs and NSOsCommon questions covered here How are NSOs taxed? How are ISOs taxed? Are ISOs or NSOs more common in startups? Show 1 more Typically, early to mid-stage companies grant stock options, which may be ISOs or NSOs.
Definition The taxes at time of exercise will depend on the gain between the strike price and the FMV, known as the spread or the bargain element.
··· The AMT TrapCommon questions covered here What are the AMT consequences of early exercise? Does the AMT apply to NSOs? How does the AMT work? Show 2 more When it comes to taxes and equity compensation, one scenario is so dangerous we give it its own section. danger If you have received an ISO, exercising it may unexpectedly trigger a big AMT bill—even before you actually make any money on a sale! If there is a large spread between the strike price and the 409A valuation, you are potentially on the hook for an enormous tax bill, even if you can’t sell the stock. This has pushed people into bankruptcy. It also caused Congress to grant a one-time forgiveness, the odds of which happening again are very low. Definition The catastrophic scenario where exercising ISOs triggers a large AMT bill, with no ability to sell the stock to pay taxes, is sometimes called the AMT trap. This infamous problem has trapped many employees and bankrupted people during past dot-com busts. Now more people know about it, but it’s still a significant obstacle to plan around. new In 2017, Congress passed the Tax Cuts and Jobs Act (TCJA), which increases AMT exemptions and their phaseout thresholds. This means fewer people will be affected by AMT in 2018 and later than in prior years.* Note that if your AMT applies to events prior to 2008, you’re off the hook. Understand this topic and talk to a professional if you exercise ISOs. The AMT trap does not apply to NSOs. ··· Stock Awards vs. ISOs vs. NSOsCommon questions covered here How are stock awards taxed compared to stock options? Are taxes the same for stock options and stock awards when they vest? Are taxes the same for stock options and stock awards when they're sold? Show 1 more Because the differences are so nuanced, what follows is a summary of the taxes on restricted stock awards, ISOs, and NSOs, from an employee’s point of view.
Mary Russell, a lawyer who specializes in equity compensation, recommends each form of equity be used at the appropriate time in private companies: restricted stock awards for the earliest stage of a startup, stock options with longer exercise windows for the early to mid stage, and RSUs for the later stages.* If you relish tax complexity, you can learn more from:
Taxes on RSUsCommon questions covered here What are the tax implications of restricted stock units (RSUs) as compensation? When am I required to pay taxes on my RSUs? How are RSUs taxed? Show 1 more If you are awarded RSUs, each unit represents one share of stock that you will be given when the units vest.
Tax Comparison TableCommon questions covered here How are different types of equity compensation taxed? How can I compare the ways equity compensation is taxed? Are all types of equity compensation taxed the same? Show 1 more Table: Comparing Taxes on Types of Equity CompensationThis table is a summary of the differences in taxation on types of equity compensation.
Tax DangersCommon questions covered here What are the most costly tax mistakes related to equity compensation? How can I avoid real tax dangers with my ISOs? What are the essential things to know to avoid huge tax bills on my equity compensation? Show 1 more Because they are so important, we list some costly errors to watch out for when it comes to taxes on equity compensation:
Plans and Scenarios12 minutes, 19 linksCommon questions covered here What are some common scenarios faced by people weighing offers that include equity compensation? What factors should I consider when deciding if I should accept an equity compensation package? What do I need to know to evaluate my offer of equity compensation? Show 7 more Evaluating Equity CompensationCommon questions covered here What do I need to know to evaluate my offer of equity compensation? What factors are most important when determining the value of an equity compensation package? Once you understand the types of equity and their tax implications, you have many of the tools you need to evaluate an offer that includes equity compensation, or to evaluate equity you currently have in a company. In summary, you have to determine or make educated guesses about several things:
That’s a lot, and even so, decisions are uncertain, but it is possible to make much more informed decisions once you have this information. What Is Private Stock Worth?We now turn to the question of determining the value of private company stock. We’ve seen how stock in private companies often can’t be sold, so its value is difficult to estimate. The value of equity you cannot yet sell is a reflection of three major concerns:
The first concern is relatively clear, if you know the company’s financials. The second and third come down to predictions and are never certain. In fact, it’s important to understand just how uncertain all three of these estimations are, depending on the stage of the company. In earlier stage private companies, there may be little or no profit, but the company may seem valuable because of high expectations that it can make future profit or be acquired. If a company like this takes money from investors, the investors determine the price they pay based on these educated guesses and market conditions. In startups there tends to be a high degree of uncertainty about the future value of equity, while in later stage private companies financials are better understood (at least to investors and others with an inside view of the company), and these predictions are often more certain. Can You Sell Private Stock?Ultimately, the value of your equity depends on whether and when you are able to convert it into stock that you sell for cash. With public companies, the answer is relatively easy to estimate—as long as there are no restrictions on your ability to sell, you know the current market value of the stock you own or might own. What about private companies? A liquidity event is usually what makes it possible for shareholders in a private company to sell their stock. However, individuals may sometimes be able to gain liquidity while a company is still private. Definition A secondary market (or secondary sale, or private sale) transaction is when private company stock is sold to another private party. This is in contrast to primary market transactions, where companies sell directly to investors. Secondary sales are not routine, but they can sometimes occur, such as when an employee sells to an accredited investor who wants to invest in the company. Definition Shares held by an employee are typically subject to a right of first refusal (ROFR) in favor of the company, meaning the employee can’t sell their shares to a third party without offering to sell their shares to the company first. caution Private sales generally require the agreement and cooperation of the company, for both contractual and practical reasons. While those who hold private stock may hope or expect they need only find a willing buyer, in practice secondary sales only work out in a few situations. Unlike a transaction on a public exchange, the buyer and seller of private company stock are not in total control of the sale. There are a few reasons why companies may not support secondary sales:
important However, participation in the secondary market has evolved in recent years,*** and a few options may be possible:
Stock Option ScenariosCommon questions covered here How should I decide when to exercise my options? How does a cashless exercise work? What is the benefit of waiting until acquisition to exercise? The key decisions around stock options are when to exercise and, if you can, when to sell. Here we lay out some common scenarios that might apply to you. Considering these scenarios and their outcomes can help you evaluate your position and decide what you should do.
important Note that some of these scenarios may require significant cash up front, so it makes sense to do the math early. If you are in a tight spot, where you may lose valuable options altogether because you don’t have the cash to exercise, it’s worth exploring each of the scenarios above, or combinations of them, such as exercising and then selling a portion to pay taxes. In addition, there are a few funds and individual investors who may be able to front you the cash to exercise or pay taxes in return for an agreement to share profits. ··· Summary of DangersCommon questions covered here What risks and dangers associated with stock options do I need to be aware of? What are the key dangers for an employee when it comes to equity compensation? What are some disadvantages of equity compensation, including stock options? Because of their importance, we’ll wind up with a recap of some of the key dangers we’ve discussed when thinking about equity compensation:
Next, we offer more details on what to ask about your offer, and how to negotiate to get the answers you want. Offers and Negotiations29 minutes, 56 linksCommon questions covered here Where can I find tips and advice for negotiating a job offer that includes equity compensation? What is a good resource for navigating the complexities of negotiation in startup job offers? Why is negotiating a job offer important? Show 25 more When a company offers any form of equity as part of its compensation package, there is a whole new set of factors for a prospective employee to consider. This chapter will help you prepare for negotiating a job offer that includes equity, covering negotiation tips and expectations, and specific reminders on what you can ask and what is negotiable when it comes to equity. Why Negotiation MattersCommon questions covered here Why is negotiating a job offer important? Am I expected to negotiate the startup job offer I received? What are the pros and cons of negotiating a job offer? Before accepting any job offer, you’ll want to negotiate firmly and fairly. You’re planning to devote a lot of your time and sanity to any full-time role; help yourself make sure that this is paidwhat you want. confusion It’s perfectly natural to be anxious about negotiations, whether you’re going through this process for the first time or the tenth. There is a lot at stake, and it can be uncomfortable and stressful to ask for things you need or want. Many people think negotiating could get the job offer revoked, so they’ll accept their offer with little or no discussion. But remember that negotiations are the first experience you’ll have of working with your new team. If you’re nervous, it can help to remind yourself why it’s important to have these conversations:
A Guide like this can’t give you personalized advice on what a reasonable offer is, as that depends greatly on your skills, the marketplace of candidates, what other offers you have, what the company can pay, what other candidates the company has found, and the company’s needs. But we can cover the basics of what to expect with offers, and advise candidates on how to approach negotiations. Equal TreatmentCommon questions covered here Are all candidates given equal treatment in the hiring process? As a hiring manager, what can I do to ensure candidates are treated equally? important Companies can and should work hard to ensure that all candidates are given equal treatment in the hiring process, but inequalities persist.* Workplace disparities in pay and opportunity span race and gender,* with research focusing on inequality in the U.S. workplace,* executive leadership and its well-documented lack of diversity,** and the technology industry.* Gender bias in negotiation itself is also an issue; many women have been made to feel that they shouldn’t ask for what they deserve.* More effort is needed to end biases and close the wage gap. All candidates should take the time to understand their worth and the specific value they can add to a company, so that they are fully prepared to negotiate for a better offer. General ExpectationsCommon questions covered here What are the general expectations around salary and equity in private company job offers? Should I use a competing offer as leverage to improve my offer from another company? For early stage startups, what expectations should candidates have about salary and equity?
OffersCommon questions covered here What are the usual components of an offer letter that includes equity compensation? What details may be part of my total compensation but not be mentioned in my offer letter? What details might my written offer letter include that were not in my verbal offer? Definition When making a job offer, companies will often give a candidate a verbal offer first, to speed things along and facilitate the negotiation, following it with a written offer if it seems like the candidate and the company are close to agreement on the terms of the offer. The written offer takes the form of an documentoffer letter, which is just the summary sent to the candidate, typically with an expiration date and other details and paperwork. Although companies often want you to sign right away to save time and effort, if you’re doing it thoughtfully you’ll also be talking to the company (typically with a hiring manager, your future manager, or a recruiter, or some combination) multiple times before signing. This helps you negotiate details and gives you a chance to get to know the people you could be working with, the company, and the role, so that you can make the best decision for your personal situation. When you are ready to accept the terms of the offer letter, you can go ahead and sign. Things to look for in the offer letter include:
While the details may not be included in your offer letter, to get full information on your total rewards you’ll also want to discuss:
A few general notes on these components (credits to Cristina Cordova for some of these):
Offers From StartupsCommon questions covered here With offers from startups, what factors should I weigh to decide how much equity versus cash is right for me? How important is job title in an offer from an early stage startup? Does the stage a startup is at affect how much cash versus equity may be offered? Because startups are so much smaller than many established companies, and because they may grow quickly, there are additional considerations worth taking into account when negotiating a job offer from a startup:
··· Questions Candidates Can AskCommon questions covered here What are the most important things to ask after receiving an offer from a startup that includes equity compensation? What should I know about percentage ownership, valuation, exercising stock options, and vesting when considering an offer from a startup? What kinds of questions can I ask to understand the benefits and drawbacks of various exercise scenarios? important It’s important to ask questions when you get an offer that includes any kind of equity. In addition to helping you learn the facts about the equity offer, the process of discussing these details can help you get a sense of the company’s transparency and responsiveness. Here are a few questions you should consider asking, especially if you’re evaluating an offer from a startup or another private company:
This information will help you consider the benefits and drawbacks of possible exercise scenarios. important If you’re considering working for a startup, there are further questions to ask in order to assess the state of the company’s business and its plans. Before or when you’re getting an offer is the right time to do this. Startups are understandably careful about sharing financial information, so you may not get full answers to all of these, but you should at least ask:
There are several other resources with more questions like this to consider. ··· Typical Employee Equity LevelsCommon questions covered here What are some benchmarks for equity compensation levels at startups? How much should an early-hire engineer expect in equity compensation from a startup? What are typical ranges for equity in early-stage startups? Compensation data is highly situational. What an employee receives in equity, cash, and benefits depends on the role they’re filling, the sector they work in, where they and the company are located, and the possible value that specific individual may bring to the company. Any compensation data out there is hard to come by. Companies often pay for this data from vendors, but it’s usually not available to candidates. For startups, a variety of data is easier to come by. We give some overview here of early-stage Silicon Valley tech startups; many of these numbers are not representative of companies of different kinds across the country:
··· Typical Startup Advisor Equity LevelsDefinition Advisors are people with extensive or unique experience who help a company in a formal or informal capacity. It is common for startups to bring on advisors with a recognized name, specific background or skills, or access to a network. Sometimes advisors act as mentors to founders.* Startup advisor compensation is usually partly or entirely via equity. Typical equity levels vary depending on the value the advisor brings, the maturity of the company, and the level of their involvement, which can vary from occasional phone-calls or introductions all the way up to being a kind of part-time, hands-on member of the team. Because advisors may not add value for as many years as an employee, a common vesting schedule for an advisor is two years with a three-month cliff. Advisor grants also typically have a longer exercise window post termination of service, and will usually have single trigger acceleration on an acquisition, because no one expects advisors to stay on with a company once it’s acquired. One commonly used framework for compensation for advisors is the FAST Agreement from the Founder Institute, an accelerator that’s been involved with over 4500 companies. Their approach is to recommend compensation based on the level of engagement (from monthly meetings to hands-on projects and help with networking) and the maturity of the company (from just an idea to growth stage, which would likely mean post-Series A):
Source: The Founder Institute’s FAST equity compensation framework Another source is Carta’s guide to advisor shares, which similarly shows most grants in the 0.2–1.0% range. Both the Founder Institute and Carta’s guide offer legal templates. Founders and advisors should consult a template and a lawyer before committing to an agreement, but these levels are reasonable reference points for both sides in negotiating fair advisor compensation. Negotiation TipsCommon questions covered here What are some tips for negotiating a good compensation package with equity? What tactics can I use to negotiate a better startup job offer? Is it legal in my state or city for a company to ask about a candidate's current and past salary when making a job offer? ··· When negotiating a job offer, companies will always ask you what you want for compensation, and you should always be cautious about answering. If you name the lowest number you’ll accept, you can be pretty sure the company’s not going to exceed it, at least not by much. caution Asking about salary expectations is a normal part of the hiring process at most companies, but asking about salary history has been banned in a growing number of states, cities, and counties.* These laws attempt to combat pay disparity* among women and minorities by making it illegal for companies to ask about or consider candidates’ current or past compensation when making them offers. Make sure you understand the laws relevant to your situation. A few points on negotiating compensation:
··· A few notes on the negotiation process itself:
Some additional resources:
Offer and Negotiation DangersCommon questions covered here What are significant dangers to be aware of when negotiating job offers with equity compensation? What are some common mistakes to avoid when negotiating a startup job offer? What are the most serious pitfalls with exercising and vesting when evaluating an offer with equity compensation? To wind up our discussion of offers and negotiations, here are some key dangers and mistakes to watch out for:
Documents and Agreements8 linksCommon questions covered here What kinds of documents should I expect to sign as part of my equity compensation package? What do stock plan and stock option agreements look like? What does an exercise agreement cover? Show 2 more This section covers a few kinds of documents you’re likely to see as you negotiate a job offer and sign on to a company. It’s not exhaustive, as titles and details vary.
Further Reading5 minutes, 49 linksCommon questions covered here What are the best online resources for understanding equity compensation? Where can I find a comprehensive reading list on equity compensation? What are essential readings on equity compensation? The resources here are a small subset of the full set of resources cited in the Guide to Equity Compensation, selected for their breadth, notability, or depth on specific issues. General Resources
Considerations for Founders
Considerations for Candidates and Employees
Types of Equity Compensation
Taxes
Vesting and Expiration of Stock Options
Negotiation
Forms and Tools
DisclaimerThis Guide and all associated comments and discussion do not constitute legal or tax advice in any respect. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. The author(s) expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this Guide or associated content. Credits11 linksCommon questions covered here Who contributed to the Holloway Guide to Equity Compensation? Who are the original authors of the Holloway Guide to Equity Compensation? Many thanks to all contributors to this Guide and those who have given detailed feedback, including Julia Evans, George Grellas, Chris McCann, Leo Polovets, Srinath Sridhar, Andy Sparks, and David Weekly, and to the many commentators on Hacker News. The original authors are Joshua Levy and Joe Wallin. Please Help!This Guide is a living publication, imperfect but improving. If you have an idea or contribution that might improve this Guide, please add suggestions in the margins. We gladly credit all contributors. LicenseThis work is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License. What is the best way to compensate employees?Seven ways to properly compensate your workers. 1) Pay them with salaries and incentives. ... . 2) Offer some stipend. ... . 3) Compensate them with paid time-off benefits. ... . 4) Reward them with free food. ... . 5) Sponsor free training courses for them. ... . 6) Provide them with insurance benefits. ... . 7) Provide them with flexible work hours.. Which of the following are included in compensation of employees?Under the terms of BPM6 § 11.17, compensation of employees has three main components: wages and salaries in cash, wages and salaries in kind, and employers' social contributions.
What are two examples of equityExamples of equity-based compensation include Stock Transfers, Stock Options, Stock Warrants, Restricted Stock, Restricted Stock Units, Phantom Stock Plans, Stock Appreciation Rights, and other awards whose value is based on the value of specified stock.
What is the most commonly used form of equity compensation?A stock option is the most commonly used form of equity compensation. It's a contract that gives the holder the right, but not the obligation, to buy or sell shares of a particular stock at a predetermined price, also known as exercise price, within a specific time frame.
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